Example Scenario
In 1995, Bob bought an apartment in Westchester County for $150,000 that was his principal residence until his employer transferred him to San Diego in 2003. Instead of selling his apartment, Bob leased it for a two year period ending on July 31, 2005. Bob has found a buyer who will pay $450,000 for the apartment and close in September 2005. Bob plans to use the sale proceeds to buy an apartment in San Diego that he plans to rent out. Bob wants to avoid paying income tax on his $300,000 profit, and he asks you if he can do a “tax free exchange.” How do you answer him?

The Answer: We have not given you enough facts to answer Bob’s question. However, you should consider the following:

1. First, you must take Section 121 of the Code into account. Section 121 says that a taxpayer may exclude $250,000 of gain on the sale
of a personal residence, if the taxpayer owned and used the property as a personal residence for at least two years out of the five year period ending with the sale. Bob can take full advantage of Section 121, because he used the apartment as his personal residence for
at least two years out of the five year period preceding the sale. Section 121 does not say that the taxpayer has to be using the property
as a personal residence at the time of sale. Bob, however, may still defer paying tax on any gain above $250,000 by engaging in an exchange under Section 1031 of the code.

2. Second, you must determine Bob’s actual gain. If Bob’s gain is only $250,000, then there is no reason to do an exchange. Even though Bob is selling his apartment for $300,000 more than he paid for it, he may be realizing a gain of less than $300,000. Other factors besides purchase and sale prices affect the amount of the gain. For example, if Bob took depreciation deductions during the period that he leased the apartment, then that will increase his gain. If Bob incurs expenses on the sale such as broker’s fees, attorney fees, and transfer taxes, then that
will reduce the gain.

3. Third, you must determine the cost of the replacement apartment in San Diego. If the San Diego apartment costs less than $450,000, then Bob most likely will be getting some cash out of the sale, and he must pay income tax on any cash received. For example, if Bob
walks out of the Westchester closing with $450,000 and buys the San Diego apartment for $400,000, then he has kept $50,000 from the sale and not used it to buy the San Diego apartment. Because only $50,000 of the gain needs to be sheltered and because Bob cannot shelter the $50,000 in cash that he received at the Westchester closing, then engaging in a 1031 exchange would be fruitless and silly.